Fourth-Quarter Market Update & Outlook
Author: Jeff Layman
The final revision to third-quarter economic growth was reported at 2 percent, continuing the slow but steady growth that has characterized the U.S. economy since 2009. The average pace of growth for the first three quarters of the year was similar at 2.2 percent.
The Fed cited improvement in a range of labor market indicators as its key rationale for raising the Fed Funds rate in December for the first time since June 2006. The Fed signaled the pace of further rate increases will be gradual and dependent on economic data trends. This suggests U.S. interest rates are likely to stay lower for longer despite the recent rate hike. Current market expectations imply two to three additional quarter point increases in 2016.
The manufacturing and services sectors continued to diverge during the final months of the year. The ISM Manufacturing Index dipped into the contraction zone in November and December, as the strong U.S. dollar and weak energy prices continue to have a negative impact on activity. Meanwhile, the ISM Non-Manufacturing Index (services sector) remains firmly in expansion territory and near 10-year highs. Strength in services is important to overall growth, since this sector is seven times larger than manufacturing in the current U.S. economy.
Consumer spending remains strong as we close out 2015 and enter the new year. Housing starts are climbing toward the long-run average, and auto sales set a record in 2015, according to Thomson Reuters. Several positive trends should support personal consumption in 2016:
- Unemployment is low and declining
- The oil and gas used to heat our homes and fuel our cars is cheap
- Borrowing rates are low
- Household net worth is at an all-time high
Government spending, the second-largest component of the economy, also is set to rise. The passage of a budget and stimulus package by Congress in December should add to economic growth in 2016. This represents a reversal from the drag that cuts in government spending have had on growth in recent years. Improvements in both consumer and government spending may allow the U.S. economy to move closer to its long-run average growth rate of 3 percent in 2016.
The stock market remained volatile during the fourth quarter but finished with gains. These gains served to offset some of the damage done in the late summer correction. U.S. stocks posted returns just above even for the year, while international stocks declined. Here are the index returns for the fourth quarter and for the full year of 2015, according to Morningstar, Inc.:
The earnings tailwind that has prevailed for several years shifted to become a headwind for U.S. stocks in 2015. S&P 500 earnings have fallen on a year-over-year basis for four straight quarters due to the effects of the strong dollar and the implosion in energy sector earnings. Although the valuation of the stock market isn’t excessive, it is full, implying stocks will have difficulty producing further gains without a return to earnings growth.
Market breadth narrowed in 2015. While large-cap stocks produced small gains, mid-cap and small-cap indexes declined 2.18 percent and 4.41 percent, respectively. Growth stocks outperformed value stocks by a whopping 9 percent, representing the worst relative performance of value versus growth in 40 years, according to Tamarac and Morningstar. Earnings growth was rare and, hence, coveted, as evidenced by the “mini technology boom” that developed in what became known as the FANG stocks. These four companies (Facebook, Amazon, Netflix and Google), which represent a combined 5.5 percent of the S&P 500 index, rose an average of 80 percent last year—despite price-to-earnings (P/E) ratios ranging from 35 to 919! Excluding these four companies and the 3.6 percent contribution they made to overall index returns, the S&P 500 index also would have posted negative returns last year.
Meanwhile, reasonably priced companies that pay strong dividends significantly underperformed. The lowest P/E companies and those that started the year with the highest dividend yields posted negative returns. Conversely, stocks with the highest P/E ratios and those that pay no dividends at all produced positive results, according to Charles Schwab.
International returns for U.S. investors were once again negatively affected by the strengthening U.S. dollar, although not to the extent of 2014. Developed international markets posted slightly negative results (-0.81 percent for the MSCI EAFE). Emerging markets, due to a strong reliance on Chinese economic growth, had a more difficult time, declining nearly 15 percent for the year, which weighed on global market returns.
Interest rates rose during the fourth quarter, as risk aversion abated and investors anticipated the first Fed rate increase. The benchmark 10-year Treasury yield increased from 2.06 percent to 2.27 percent during the period.
The increase in interest rates caused slightly negative total returns for the Barclays Aggregate taxable bond index, down 0.57 percent for the quarter. While still positive, this brought full-year returns to just 0.55 percent. Despite certain high-profile credit concerns, e.g., Puerto Rico, developing during the year, municipal bonds were the best performing major asset class in 2015. The Barclays Municipal Bond Index gained 1.5 percent for the quarter and 3.3 percent for the full year.
In the satellite bond category, emerging markets debt posted slightly positive results, with the J.P. Morgan EMBI index up 0.81 percent. Since a significant portion of this debt is dollar-denominated, emerging markets bonds fared much better than emerging markets stocks due to minimal exposure to the currency effect. The corporate high-yield area had a tough time in 2015, with losses greater than 5 percent. This was primarily due to significant deterioration in energy-related issues, although spreads widened across other sectors as well. This is the first year on record that high-yield corporate bonds have posted negative returns of this magnitude outside of an economic recession.
Last year was a challenging one for investors, but it was by no means disastrous. U.S. stocks experienced a midyear correction, while certain asset classes such as commodities and emerging markets stocks entered bear market territory. The best-performing asset class—municipal bonds—generated a return of only 3 percent. Hence, most diversified portfolios finished near even on the year, plus or minus a bit depending on specific allocation.
As we transition to a new year, the investment environment is changing. After seven years of zero interest rate policy, the Fed has begun to raise short-term rates. Inflation expectations also are beginning to rise after a period of flat consumer prices. Corporate earnings have declined in the U.S., following six years of significant growth. Finally, market volatility has increased after several tranquil years, due to concerns about the trajectory of global growth.
Taking a longer-term look back at asset class returns, U.S. stocks have been the clear leader over the past five years, posting average annual returns in the low teens. These returns are well above the historical average of about 9 percent. Meanwhile, most of the asset classes used to diversify portfolios have disappointed. International stocks have produced returns of roughly half their long-run norm. Most alternative investment strategies have generated low- to mid-single-digit performance, also far below expectations. Cash and short-term bonds have generated little or no return over the trailing five-year time frame.
Prudent portfolio diversification hasn’t been particularly rewarding in recent periods, given the wide performance gap between U.S. stocks and just about everything else. Some investors may be tempted to abandon diversification and risk management in favor of increasing their allocation to U.S. stocks given that this has been the best-performing asset class in recent years. However, history would suggest this is a mistake since asset classes tend to revert to the mean or move back toward long-run average returns after significant periods of over- or underperformance. This is likely to eventually lead to a prolonged period of outperformance from the diversifying asset classes.
Conditions are changing, and investing to manage risk exposure to protect against inflation and toward asset classes that offer attractive return potential is more important than ever. Disciplined rebalancing is hard for many investors in periods like this, because buying what hasn’t performed well is counterintuitive to most. We’re using the current period of increased volatility to reposition portfolios for 2016 and beyond in a manner consistent with our core investment beliefs, which include emphasizing attractively valued investments within a globally diversified framework. We appreciate the confidence you have placed in our team, and we wish you peace and prosperity in 2016!
Jeffrey A. Layman, CFA®
Chief Investment Officer
BKD Wealth Advisors, LLC is an SEC-registered investment adviser offering wealth management services for affluent families and investment consulting services for institutional clients and is a wholly owned subsidiary of BKD, LLP. The views are as of the date of this publication and are subject to change. Different types of investments involve varying risks, and it should not be assumed that future performance of any investment or investment strategy or any noninvestment-related content will equal historical performance level(s), be suitable for your individual situation or prove successful. A copy of BKD Wealth Advisors' current written disclosure statement is available upon request.